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Intuitive Surgical Inc. (NASDAQ:ISRG)

Q3 2007 Conference Call

October 18, 2007 4.30 pm ET

Executives

Cindy Marple - IR

Lonnie Smith - Chairman and CEO

Marshall Mohr - CFO

Ben Gong - VP, Finance

Aleks Cukic - VP, Business Development and Strategic Planning

Jerry McNamara - EVP, Worldwide Sales and Marketing

Analysts

Tao Levy - Deutsche Bank Securities

Mimi Pham - HSBC

Tim Nelson - Piper Jaffray

Eli Kammerman - Cowen

Vincent Reece - Wachovia

Rick Wise - Bear Stearns

David Louis - Morgan Stanley

Operator

Good afternoon and thank you for standing by. At this time,all participants are in a listen-only mode. After the presentation, we willconduct a question-and-answer session. (Operator Instructions). I would like tointroduce your conference host for today’s call Ms. Cindy Marple. Ma’am you maybegin.

Cindy Marple

Good afternoon, and welcome to Intuitive Surgical's ThirdQuarter Conference Call. With me today, we have Lonnie Smith, our Chairman andCEO; Marshall Mohr, our Chief Financial Officer; Ben Gong, our Vice Presidentof Finance; Aleks Cukic, our Vice President of Business Development andStrategic Planning; Gary Guthart, our President and Chief Operating Officer;and Jerry McNamara, our Executive Vice President of Worldwide Sales andMarketing.

Before we begin, I would like to inform you that commentsmentioned on today's call may be deemed to contain forward-looking statements.Actual results may differ materially from those expressed or implied as aresult of certain risks and uncertainties.

These risks and uncertainties are described in detail in thecompany's Securities and Exchange Commission filings. Prospective investors arecautioned not to place undue reliance on such forward-looking statements.

Please note that this conference call will be available foraudio replay on our website at IntuitiveSurgical.com, on the audio archivesection under our Investor Relations page. In addition, today's press releasehas been posted to our website.

Today's format will consist of providing you with highlightsof our third quarter as described in our press release announced earlier today,followed by a question-and-answer session.

First, Lonnie will present the quarter's businesshighlights, Marshallwill follow with a review of our third quarters’ financial results. Next Alekswill discuss sales and marketing highlights; then Ben will provide our updatedfinancial forecast for 2007. And finally, we will host a question-and-answersession.

With that, I would like to introduce Lonnie Smith, ourChairman and CEO.

Lonnie Smith

Thank you for joining us today. As you can see from ourpress release, we continue to drive the adoption curve, robotically assistedsurgery, and continue to deliver significant top-line and bottom-line growth.

Operating highlights for the third quarter are as follows.Total revenue grew to $157 million, up 64% from last year. Instrument andaccessory revenue increased to $49.5 million, up 70%. Total recurring revenueincluding service grew to $71 million, up 64% from the prior year, comprising45% of total revenue.

We sold 63 da Vinci surgical systems, up from 46 during thethird quarter of last year. Positive systems were second, third, and fifthsystems to existing customers.

Our international team had an excellent quarter contributing17 of the 63 systems sold. We ended the third quarter with 719 systemsinstalled worldwide.

We generated an operating profit of $63 million, 40% revenuebefore non-cash 123R stock option expense, up 92% in the third quarter of lastyear. GAAP net income before unusual operating income items grew to $37million; 24% of revenue, up a 116% from last year.

We ended the quarter with $533 million in cash andinvestments, up $86 million from last quarter. During the past nine months wehave generated $203 million in cash, which excluding $42 million cash receivedfrom exercise of stock options amounts to 169% of our reported GAAP net income.

This is reflection of the significant non-cash stock optionand statutory tax expenses reflected in our GAAP net income. And as a reason ofthat we continue to believe that operating income before non-cash 123R stockoption expense remains the best measure of our true financial performance.

The da Vinci S continued to dominate our systems mix,accounting for 95% of the systems sold in the quarter. High definition visionsystems accounted for 68% of the systems. We launched the Hem-o-lock clipapplier, the G 400 compatible, Endo PK a Dissecting Forceps and a new smoke evacuating8 millimeter Cannula.

We grew our Intuitive team by 38 members this past quarterto 697. We continue to see solid procedure growth. Year-over-year prior growthremained strong, while quarter-over-quarter sequential growth was impacted bysummer vacations, particularly in Europe.Procedure growth and adoption continues to be procedure specific, patientdriven and the primary growth driver of our business.

With that I will pass the time over to Marshall Mohr ourChief Financial Officer.

Marshall Mohr

Thank you, Lonnie. Total third quarter revenue increased to$156.9 million, up 64% from $95.8 million for the third quarter of 2006, and up12% from $140.2 million for the second quarter of 2007. Our revenue growth isdriven by procedure adoption, which was consistent with our previous guidance.Da Vinci hysterectomy and prostatectomy continue to be the primary drivers ofour business.

Third quarter revenues by product category were as follows;instrument and accessory revenue increased to $49.5 million, up 70% comparedwith $29 million last year and 8% compared with $45.8 million last quarter. Thegrowth rate in instruments and accessories is comparable to and a direct resultof our procedure growth rates. Third quarter revenue growth rate of 8% reflectsthe expected impact of seasonality, particularly overseas.

The amount of instrument and accessory revenue we earn perprocedure remained relatively unchanged at between $1,500 and $2,000 perprocedure per established da Vinci accounts. Including the impact of initialorders completed with new system purchases, instrument and accessory revenuecontinues to be between $2,000 to $2,500 per procedure.

Systems revenue increased to $85.5 million, up 63%, comparedwith $52.4 million last year and up 15% compared with $74.1 million lastquarter. The increase in systems revenue reflects increased unit sales as wellas an increase in the average revenue per system.

Third quarter da Vinci Surgical System revenue reflects thesale of 63 systems, compared with 46 systems during the third quarter of lastyear and 56 systems sold in the second quarter. 43 of the systems sold duringthe quarter were our latest S model incorporating high-definition visioncapabilities; 13 with four-arm S models incorporating standard visioncapabilities; four were three-arm S models, and three were standard systems.

Our third quarter average revenue per system including allda Vinci models, but excluding upgrades was $1.33 million, which is $25,000more than the average revenue per system in the second quarter of 2007. Thehigher average revenue per system primarily reflects a favorable geographicmix, including direct sales to European customers, which are denominated inEuros, which strengthened relative to the dollar this quarter.

Upgrades including 4th arm in HD, accounted for $1.6 millionof the current quarter systems revenue, compared with 1.1 million last quarter.Service and training revenue increased to $21.9 million, up 52% compared with$14.4 million last year, and up 7% compared with $20.3 million last quarter.

The growth in service and training revenue is primarilydriven by a larger system installed base, as well as, higher annual contractprices associated with da Vinci S and HD models.

Total third quarter recurring revenue comprised of instrument,accessory, service and training revenue increased to $71.3 million, up 64%compared with the third quarter of 2006, and up 8% compared with the secondquarter of 2007.

Recurring revenue represented 45% of the total third quarterrevenue, compared with 47% in the second quarter, reflecting the significantincrease in the system sales.

Revenue outside the United States represented 22% oftotal third quarter revenue, compared to 19% in the second quarter. The growthin international revenue reflects 17 system sales, compared with 12 in thesecond quarter; and lower instrument and accessory revenue growth, reflectingseasonality associated with summer vacations.

Our third quarter 2007 gross margin of 69.1% increased,compared with 67.1% realized in the second quarter. The increase in grossmargin reflects higher system selling prices in favorable manufacturingabsorption. Total operating expenses for the third quarter of 2007 were $54.1million, compared with 49.1 million in the second quarter of 2007.

The sequential operating expense increase of 5.4 millionreflects increased spending in R&D, increased headcount, and increases inother cost associated with growth in our top-line, partially offset by areduction in non-cash 123R stock compensation expense.

We added 38 employees during the quarter, ending the periodwith 697 regular employees. Majority of the additions were to our world-widesales and support and manufacturing organizations.

Third quarter 2007 operating income was $54 million or 34.4%of sales, compared with 45 million or 32.1% of sales for the second quarter of2007. Our third quarter 2007 other income of $12.2 million increased ascompared with $5.2 million in the second quarter of 2007.

Our third quarter 2007 other income included a $4.1 milliongain on the sale of Hanson Medical [chairs] and $1.8 million of foreignexchange gain associated with the increase in Euro relative to the U.S. dollar.Excluding these gains, the increase of 1.1 million is primarily the result ofinterest earned on greater cash and investment balances.

Our effective tax rate for the third quarter was 38.2%,which is slightly lower than the 39% we recorded in the second quarter. Ourthird quarter tax rate reflected certain one-time benefits, and we expect ouron-going tax rate to be around 39%.

We continue to utilize net loss carry forwards and employeestock-related tax benefits in 2007. The amount of employee stock-related taxbenefits increased in the third quarter, such that we now expect our cash outlayas a percentage of pre-tax will be less than 10% for 2007.

Our international tax structuring activities are proceedingon schedule, but will not generate a reduction in our global tax rate untilafter 2008.

Our net income increased to $40.9 million, or $1.04 pershare, up 137% compared with $17.3 million, or $0.45 per share for the thirdquarter of 2006, and up 33% compared with $30.7 million, or $0.79 per share forthe second quarter of 2007.

Excluding the gain on the sale of Hansen shares and the foreignexchange gains, net income for the third quarter was $37.2 million or $0.95 pershare.

Let me quickly summarize our results for the first ninemonths of 2007. Total revenue for the first nine months of 2007 was $411.4million, up 58%, compared with $260.1 million last year.

Operating income for the first nine months of 2007 was$133.4 million, up 85%, compared with $71.9 million last year. Operating incomeincluded $26.2 million of stock-based compensation charges in the first ninemonths of 2007, compared with $18.5 million in 2006.

Net income for the first nine months of 2007 was $95.4million or $2.46 per share, up 97% compared with $48.4 million or $1.27 pershare last year. Excluding the gain on the sale of Hansen shares and theforeign exchange gain, net income for the first nine months was $91.5 millionor $2.36 per share.

Now, turning our attention to the balance sheet. We endedthe third quarter of 2007 with cash, cash equivalents, and investments of $533million, up $86 from the previous quarter end, and $203 million from December31, 2006. $21 million of the cash generated in the quarter and $42 million ofthe cash generated in the nine-period was associated with stock purchaseactivities. The remaining cash generated is primarily related to operatingactivities.

Our accounts receivable balance increased to $120.5 millionat September 30th, from $105.6 million at June 30, 2007. The increase inaccounts receivable is attributed to increased sales.

Our net inventory increased $26.8 million at September 30,2007 from $24 million at June 30, 2007. Our inventory turns at September 30,2007 of seven times per year were slightly lower then the 7.4 turns at the endof the previous quarter.

And with that I would like to turn it over to Aleks who willgo over our sales, marketing and clinical highlights.

Aleks Cukic

Thank you, Marshal. During the third quarter we shipped 63da Vinci systems, 46 systems in the United States,11 in to Europe and six in to rest of worldmarkets. 60 of the 63 system shipments were da Vinci S systems, four of whichwere three-armed S systems, while the remaining three were standard da Vincisystems. Of the 60 S systems sold, 43 were high-definition or HD systems. Wehad no trade-ins during the quarter.

The 63 systems sold brings to 719 accumulative da Vincisystems worldwide; 545 in the U.S, 119 in Europeand 55 in rest of world markets. 5 of the 63 systems sold during the quarterrepresented repeat system sales to existing customers. Repeat systems salesincluded the Cleveland Clinic, NorthwesternUniversity Hospital,the Lahey Clinic and Hackensack Medical Center.The sale to Hackensackrepresented their fifth da Vinci system.

Internationally we had an excellent quarter, which includedfive additional da Vinci systems into Belgium,three into Korea and ourfirst system into Russia.Clinically we had another good quarter. There was seasonally slow quarter forelective surgeries. We experienced solid sequential procedure growth. Ourgynecologic procedure business paced by da Vinci Hysterectomy, registered thelargest sequential percentage growth for the quarter, followed by Urology.

Ben will provide you with updated procedure guidance duringhis review. We had 57 da Vinci related clinical papers published within the variouspeer-reviewed journals. We also launched three new products the Hem-o-Lock clipapplier, which was developed in collaboration with Teleflex Medical. The G 400compatible and Endo PK Dissecting Forceps which was developed in collaborationwith Gyrus ACMI and the 8 mm Cannula with a smoke evacuation outlet.

Although none of these products is expected to significantlyboost our top-line, each will offer our surging customers added utility,leading to a more optimized surgical procedure. We are building this procedurebusiness one procedure at a time and therefore optimizing each of our targetprocedures through the development of new products and product enhancementsremains an important priority.

Of the peer-reviewed literature I mentioned there is oneparticular study I'll bring to your attention. In the October 8th edition ofthe Archives of Internal Medicine, a study entitled short and long termmortality of localized prostate cancer set out to compare survival rates forprostate cancer patients undergoing primary radiation therapy, radicalprostatectomy, as well as other treatment options. The consortium of authorsrepresented surgical departments, radio-oncology divisions and cancerregistries from Geneva University in Geneva, Switzerland, the National University ofSingapore, and the University of Turin in Turin, Italy.

The population cohort included 844 men that have beendiagnosed with localized prostate cancer. 158 of these mentioned underwent aprostatectomy. 205 were treated with radiotherapy, 378 selected a watchfulwaiting regiment, 72 received hormone therapy and 31 were treated with othertherapies

The result, at five years, the survival rates were fairlyconsistent between cohorts, except for the hormone therapy cohort, which wasstatistically inferior to the other treatments. However, at 10 years, thesurvival results changed materially. The prostatectomy cohort showed an 83%survival rate, radiotherapy 75%, watchful waiting 72%, but when you look alittle closer at the data, specifically within the larger segment, men under 70years of age, the survival rate gap between prostatectomy and radiotherapywidened to 92% compared with 78% respectively.

Said another way, the study reported that for man under theage of 70 with localized prostate cancer, the risk of dying from the diseasewithin 10 years, following prostatectomy was 8%, as compared with 22% followingradiotherapy. The author's conclusion and I quote "our study resultssuggest that surgery offers the best chance of long-term prostate cancerspecific survival, in particular for younger patients with poorlydifferentiated tumor"

Many of our customers have reported shifts in theirhospital's treatment mix away from primary radio therapy toward dVP. With theincreased awareness for earlier PSA testing leading to earlier stage diseasedetection in younger patients, we would expect this mix shift to continue.

We participated in multiple conferences within urology,gynecology, general surgery, and cardiothoracic surgery during the quarter.However, I’ll limit my review to only two. This year was the first time weattended the American Urogynecology Society Conference or the AUGS, which tookplace in Floridaand was attended by approximately 900 urogynecologists.

Urogynecologist are the specialists, which among otherthings, focus on the condition of vaginal vault and uterine prolapse, whichlead to pelvic floor and vaginal vault reconstructed procedures.

The society put da Vinci front and center at the conference.The post graduate course entitled, The Surgical Management of Pelvic OrganProlapse focused on da Vinci’s roll within these prolapsed procedures, and wasone of the most popular courses offered.

The satellite symposium entitled, Robotic Applications toSurgically Repair Vaginal Vault and Uterine Prolapse was in fact the mostpopular symposium at this year’s conference. It was so well attended that theorganizers had to move it to a larger venue to accommodate the standing[remaining] crowd.

Dr. Tony Visco from Duke Universitypresented his experience, rationale, and surgical technique for da Vincisacrocolpopexy. Followed by Dr. Arleen Song from the University of Michigan,who covered da Vinci Hysterectomy for those patients that required removal ofthe uterus prior to sacrocolpopexy.

The rationale for da Vinci's use within these complexoperations is very consistent with our Patient Value equation, which translatesinto efficacy over invasiveness, which in this case means eliminating a largeopen incision to create what is considered a durable gold standard repairprocedure.

Overlapping the AUGS Conference was the Mayo Clinic'sAdvance Techniques in Endoscopic and Robotic Gynecologic Surgery Symposium,which took place in Maui. Perhaps the mostnotable at this year's program was da Vinci's role within all sub-specialtycategories of gynecology, which include GYN Oncology, Laparoscopic GYN,Urogynecology, and Reproductive surgery.

Presentations were made by Mayo Clinic staff surgeons andguest faculty on da Vinci Hysterectomy for endometrial and cervical cancer, daVinci Hysterectomy for Benign Disease, da Vinci Sacrocolpopexy, Myomectomy andfor Excision of Invasive Endometriosis.

As we are experiencing in urology, establishing a strongclinical story around a common, but complex procedure provides us with theopportunity to expand da Vinci's utility within an entire specialty. And in thecase of the GYN specialty, that procedure is da Vinci Hysterectomy; and it'sbrought a new awareness to minimizing the invasiveness of other complex GYNprocedures.

In the fourth quarter we will be participating in severalkey GYN conferences, including the European Society of GYN Oncology Conference,which takes place in Berlin; The AAGLConference in Washington DC;and the First Annual International Robotic GYN Oncology Symposium, which issaid to take place at the Universityof North Carolina in Chapel Hill.

That concludes my overview, and I will now pass the timeover to Ben.

Ben Gong

Thank you, Aleks. As in previous earnings calls, I will beproviding our updated forecast on a GAAP reporting basis, including stockcompensation expenses. I will also provide an estimate of the stockcompensation expenses separately, so you can calculate meaningful comparisonsthat exclude these non-cash expenses.

As previously mentioned, we had better than anticipatedgrowth in revenue and profit in the third quarter, and we expect this momentumto continue through the remainder of the year. Therefore we are increasing ourprevious guidance for revenue and profit for 2007.

Starting with procedure growth, we continue to expect dVPand dVH adoption to drive the growth in our recurring revenues. Our proceduresperformed in Q3 were inline with our expectation for these areas, and wecontinue to expect dVP growth for the year to be at least 65%. We also continueto expect dVH growth for the year to exceed 175%.

Instrument and accessory revenues are expected to growbetween 70% and 75% over 2006. This is consistent with our forecast from ourlast earnings call, and it reflects our overall procedure growth from lastyear.

Our systems sales were strong in the third quarter acrossboth domestic and international markets, and we expect to have continued growthin system unit placements in the fourth quarter. We are now forecasting systemrevenue to grow between 48% and 52% over 2006, which is up from our perviousforecast of 30% to 35%.

A majority of this growth is resulting from an increase inunit shipments, while part of this growth is also driven by higher averageselling prices for systems compared with the prior year. Our system ASP wasapproximately $1.33 million for the third quarter, and $1.3 million evenyear-to-date. For the fourth quarter we expect our system ASP to beapproximately $1.3 million.

We expect service revenues to grow approximately 52% above2006 levels, up from our previous forecast of 50% growth. This increase isdriven our higher system placement this year.

Overall, we now expect our total 2007 revenues to growapproximately 55% to 58% over 2006, compared to 45% to 50% previously forecast.

With regard to gross profit margin, we had an up tick in thethird quarter, driven primarily by higher average selling prices from favorablegeography mix and by manufacturing productivity improvements. We expect tomaintain the benefit from productivity improvement through Q4. However, wewould be cautious about predicting the same favorable geographic mix we had inQ3. Therefore, we are forecasting gross margins to be approximately 68% for boththe fourth quarter and the year-end.

Moving to operating expense, we are also expecting to spendmore on both R&D and SG&A expenses then we previously forecast. First,higher revenues are driving higher sales commissions, which are reflected inSG&A expense. We expect our SG&A expense to grow between 41% and 45%for the year, which is up about 1 percentage point from our previous forecast.

In the R&D expense category, we've mentioned in our lastearnings call, we have stepped up our investment in internal projects, as wellas co-development projects with third-party corporate partners. We arecontinuing to increase our activities in these areas. In total, we expect ourR&D expense for 2007 to be 55% to 60% higher than our R&D expense for2006, which is up from our previous forecast of 48% to 52%.

We expect our total operating expense for 2007 to be 45% to47% higher than our total operating expense in 2006. These forecast for grossmargin and operating expense, include the impact of FAS 123R stock compensationexpense. Our third quarter operating income included $8.7 million of non-cashstock compensation expenses allocated as follows; $1.4 million in cost ofsales, $5.2 million in SG&A and $2.1 million in R&D. For the year, weexpect the impact of FAS 123R to be between $35 million and $36 million withthe percentage allocation to P&L lines consistent with Q3.

Other income expense for the third quarter included $6million of income, which we did not expect to repeat in the fourth quarter,specifically, gains on sale of equity investment and foreign exchange gains.Interest income for the fourth quarter is expected to be between $6.5 millionand $7 million. For the year, we expect total other income and expense to bebetween $28 million and $29 million.

With regard to income tax, we expect to report a GAAP taxrate of 39% for the fourth quarter, which will result in an annual GAAP taxrate of between 38.5% and 39%. However, we expect our effective cash taxexpense to be less than 10% for 2007.

Regarding shares outstanding, we currently have 38.2 millioncommon shares outstanding, and we also have approximately $3.3 million optionshares outstanding. Depending upon our average stock price during the fourthquarter, a portion of the 3.3 million option shares will be added to the fullydiluted shares calculations. Calculating EPS in Q4, we expect the share countto be approximately 39.5 million shares.

By concluding our prepared remarks, we will now open thecall to your questions.

Question-and-AnswerSession

Operator

Thank you. (Operator Instructions). Mr. Tao Levy, you mayask your question.

Tao Levy - DeutscheBank Securities

Good afternoon everyone.

Jerry Mcnamara

Hi Tao.

Tao Levy - DeutscheBank Securities

Hi. I guess my first question, on the strength in theinternational market, it seems like Belgium, the folks over there getreal excited about robotic surgery. Maybe you could talk about how thatdevelopment happened. Was it the government that ended up purchasing the fivesystems or is it a group of hospitals?

Jerry Mcnamara

Tao, this is Jerry. We have been growing our procedures in Belgium overtime and we have had installationsin Belgiumsince early 2000s. And at the beginning of Q3 we had 10 sites up and runningand we have been extremely well staffed and this really set the table to beable to sell five additional new systems during the quarter. So, now that toanswer your last question and I have nothing to do with the government.

Tao Levy - DeutscheBank

Is it something that you think international will continueto see, not necessarily in Belgium,but across other areas?

Jerry Mcnamara

Well, business is generally strong internationally. Thatbeing said, procedures were seasonally softer in the third quarter as weexperienced long vacation times for both patients and physicians. Overall, weexpect to see a lot of continued growth in the US and for the rest of the year weare not expecting or forecasting a higher percentage of business internationalsales than what we have seen earlier this year.

Tao Levy - DeutscheBank

Alright, and if I look at the full year guidance, I guesseffectively the fourth quarter, Ben, the right way to think about systemplacements in terms of total number is this somewhat slightly higher than thethird quarter. Is that the, if I do the math quickly?

Ben Gong

Yeah, we are expecting some sequential unit growth in fourthquarter over the third quarter and that's incorporated in that new systemrevenue guidance of 48% to 52%.

Tao Levy - DeutscheBank

Perfect. And then just lastly, what's the capital spendingenvironment like in the hospitals these days just given some of the creditconcerns. Obviously, given the third quarter didn't seem like there was anyimpact. But as you go ahead and start to talk to at the hospitals oradministrators, any changes there that we should be looking at?

Jerry McNamara

Tao, this is Jerry. No negative changes, actually we see ourpipeline for Greenfieldand repeat system sales to be stronger than ever.

Tao Levy - DeutscheBank Securities

Great, thanks a lot.

Operator

Mimi Pham of HSBC, you may ask your question.

Mimi Pham - HSBC

Hi good afternoon. For international geographies, do youplan on expanding into any new geographies next year that aren't earlier andselling in now?

Ben Gong

Mimi, this is Ben. We mentioned that we just sold our firstsystem into Russia.

Mimi Pham - HSBC

Yes.

Ben Gong

And one thing that we see is, you first place something intoa new geography and it takes a little bit of time for that geography todevelop. So you're seeing that with places like Korea. And so we expect that, nowthat we got our first one into Russia, maybe there will be some activitiesthere not right away, but maybe a couple of years down the road.

Mimi Pham - HSBC

And in these international markets, are they being drivenmainly by da Vinci Prostatectomy and Hysterectomy like in the US.

Ben Gong

Primarily urology is strongest outside the United States. Many of thoseterritories lag the US by about two years, and so right now one of our biggestgrowth drivers in Europe is dVP, and likewise in Asia some of the activitieswe're seeing there are primarily urology at this point.

Aleks Cukic

But within, for example, Korea which was also a strongmarket for us specifically this quarter, you see multiple specialty focusedrobotics programs that include general surgery that include cardiac surgery.It's fair to say prostate is a big driver, but its not limited toProstatectomy.

Mimi Pham - HSBC

Thanks. And on the margin side, can you break up the productmargins for the disposables in the system, and what would consider the ceiling?

Ben Gong

We did tick the gross margin guidance by about 1 point, andyou saw that we got two points better this quarter than last quarter. So, thebig drivers for that were some manufacturing improvements as well as ASPimprovements, but some of that was from foreign gains.

It's not materially different than what we had before, soyou have product gross margins somewhere on the order of 17%, and that'sroughly the amount for systems and for instruments and accessories alike, andyou still have the gross margins for a service lower than that, due to the waywe account for the training expenses.

Mimi Pham - HSBC

But in terms of a ceiling is there?

Lonnie Smith

Let me comment on that. We've got strong margins, we'llcontinue to drive efficiency. But I am not sure, we're going to try to drivethat in to margins, and maybe more deliver it back to our customer. And so Iwouldn't plan on expanding margins dramatically, even though we may drive costdown pretty dramatically or we will continue to do it.

I think we are not -- there comes the point where we want abalance this in fairness to our customers as well, and so we will share some ofthe benefits with them.

Operator

Mr. Tim Nelson of Piper Jaffray, you may ask your question.

Tim Nelson - PiperJaffray

Hi, you talked a little bit about seasonal slow down inprocedure growth rates, was that any different between OUS and US geographies?We expect that sort of thing in and outside we've heard you pronounced it.

Lonnie Smith

Clearly more pronounced in the overseas markets.

Jerry McNamara

And it was similar to our experience in the last few yearsTim.

Tim Nelson - PiperJaffray

Could you comment on what the differential utilization rateare between your installed base outside the United States and in US.

Ben Gong

Just repeating some of the stuff we said in the past. Theoverall utilization rate internationally is a little bit lower than in United States, but there are certainly pockets,lets say in Scandinavia or let's say in Belgium where you have utilizationrates that are actually pretty similar.

But since there are typically newer users out thereinternationally, you don't have the same sort of overall productivity on thosesides as a whole.

Tim Nelson - PiperJaffray

Okay. And you also mentioned strong pipeline on systems. Canyou again give us some feel for the geographic split for that? Is the strengthof the pipeline for here in the United Statesand outside the United States equally or is there somedifferential?

Lonnie Smith

I think it's pretty consistent globally.

Tim Nelson - PiperJaffray

Okay. And then you did have -- I am curious on your expectedgrowth for dVP and dVH for the year, because you commented on what it was inthe quarter?

Ben Gong

No I guess that what's indicative is we have the sameforecast for the year as we did last quarter. So, our growth in the quarter wasin line with what we are expecting and therefore for the year it's about thesame.

And then the [repeat], the overall procedure growth like theinstrument and accessory growth for the year is expected to be 70% to 75% andthe biggest drivers continue to be dVP at least 65% and dVH at least a 175%.

Tim Nelson - PiperJaffray

Okay. And we are really starting to get some good tractionin dVH outside of the oncology's segment, are you seeing an acceleration there?

Aleks Cukic

I don't know Tim that I would use terms like acceleration.We are getting I think very strong representation both within the oncology aswell as the complex benign cohort. And I will tell you that we are picking upsome momentum in things like sacrocolpopexy and Myomectomy. So I would say it'ssort of a global statement that the category of GYN is coming along quitenicely, similar to how we had talked about in the past it seems to be unfoldingthat way.

Tim Nelson - PiperJaffray

Great.

Lonnie Smith

And just a comment on dVH and what's driving the underlyinggrowth, and I think this is more than just dVH, but it's the patient behaviorin terms of speaking, what I'd say our higher value-added treatments.

I recently spoke with a Senior Executive of a large publiccompany. And I was surprised that he was familiar with our company. And I askedhim about it and he said, well, his wife was diagnosed with endometriosis andrequired a hysterectomy. And she then went to a GYN of 17 years who hasdelivered two of their children and told him that she was interested in havingit done robotically as she was been on the internet. And his response wasfirst, I would never heard of hysterectomy performed by a robot. His secondresponse was, wouldn't it be nice if a robot could do everything that I do. Andlast he said, I think it's ridiculous. So, what do you think she did?

Tim Nelson - PiperJaffray

She went to find somebody who could do it robotically?

Lonnie Smith

Find the right oncologist, that's right, who did herprocedural robotically. I tell that story only because I think it'sfundamentally, it is what is underlying the growth of our company. It's thatmore and more patients are proactive in seeking treatments that providesuperior outcomes to them in terms of effectiveness and impact on their dailylives and it's certainly true, GYN with hysterectomies, sacrocolpopexies,myomectomies, as Aleks has mentioned.

Tim Nelson - PiperJaffray

That's very interesting, because you generally think ofwomen having much great loyalty to their OB/GYN and men to their urologist, soI am glad to hear that. Okay, thank you.

Operator

Eli Kammerman of Cowen, you may ask your question.

Eli Kammerman - Cowen

Thanks very much. My first question is about two years agoin the third quarter of '05, you had margins that were pretty similar to the marginsyou just reported and I am wondering if the reasons were similar then orsomething else happened two years ago to make the gross margin and theoperating margin tick up so much for that period?

Ben Gong

Two years ago we did not have SFAS 123R and when we startedreporting stock compensation expenses, remember it hits the gross margin line,as well as the operating expense line. When you saw a down tick, I am thinkingthis is what you are asking, when you saw a decrease in the gross margin line,part of it was that stock compensation expense and then now that we've gottensome of these productive gains that we talked about, now we are back at thelevel that perhaps we were at before SFAS 123R.

Eli Kammerman - Cowen

Okay. All right, all right. The other question I have is,are you actively encouraging or promoting new uses in surgical oncology,specifically for rectal cancer? And can you just describe what's going on inthat particular surgery it does seem to bear some physical resemblance to lot ofthe other types of lower pelvic surgeries?

Aleks Cukic

Yeah, that's a good observation and obviously you aredealing in a narrow male pelvic region, which is very similar to prostatectomyand the vascularity associated with that region is pretty high and the area orthe work area is very tight. So, it does set up pretty well for the things thatwe have seen da Vinci do well at.

We just came off the ACS Meeting literally last week andthere seems to be a, I don't want to say renewed interest, because there isalways been interest, but more interest than in the past and continuing to moveminimally invasive surgery through colon and rectal surgery. There have been alot of attempts at it. There is hand assist approaches and what not. But, it issomething that we are looking at. I think we have a fair amount of interest outthere. As far as promoting, I wouldn't use that term because we are exploring,I think it's probably a better term, but there is a lot of interest that's outthere right now.

Eli Kammerman - Cowen

Alright, thanks very much for those answers.

Operator

Our next question comes from Vincent [Reece] from Wachovia.Your line is open.

Vincent Reece -Wachovia

Hi guys. Can you talk just a little bit about the ventureyou guys did with Cardica with the C-Port Flex A. I think you guys haveperformed the surgery with them and just how that effects what you are lookingat in cardiothoracic?

Aleks Cukic

I think, there is no venture with Cardica. I think you areprobably referring to a couple of press releases around one of our customersthat incorporated one of their products with the da Vinci operation. And so,there is really not a lot to comment on there. I mean, we've worked with a lotof companies and we've worked with a lot of companies in that particular spaceover the years, Cardica being one of them. But, there certainly isn't anyventure there and how it effects what we are doing, it’s speculative certainlyat best at this point. So, we'll let the customers decide where and how theycan use our system and where and how they can use their system. And if there isa natural intersection point that will be great.

Lonnie Smith

The time will tell. I mean, they've got some interestingtechnology, they are working on it, they have done and we support everyone whohelps us to drive cardiac to a more minimal invasive procedure.

Vincent Reece -Wachovia

Okay, great. And in urology, are you still seeing erosion ofsome of these other competing paradigms, and more specifically with radiationtherapy is it a brachytherapy, first is directed beam radiation or both of thembeing impacted or is it more of a watchful waiting?

Aleks Cukic

It's really hard for us to tell you, it's such a dynamicsituation, and all we really have to go on what our customers are telling us.We've had situations where large brachytherapy based programs have moved a lotof those patients to da Vinci Prostatectomy. We have examples of primaryradiation treatments; again that were fairly large in numbers that havereduced.

But at the same time, there is always and we shouldn't sayalways, but there is a combination of both of them in many operations, wherethere is some cancer that's remaining and they will use external beam and cleanup procedures. There is just a lot of movement that's going on, so I think itwould be difficult for us to tell you exactly what that looks like.

But it is something that we are hearing is continuing, andas patients and younger patients are getting diagnosed, the data I thinksupports now, again there is another piece of data that's out there, thatsupports long-term survival and prostatectomy. And so, that I think as thepatient becomes more informed becomes a bigger consideration.

Vincent Reece -Wachovia

Okay, great. And then finally with that international itseems that there was a little bit more acceleration rest of world than Europe. Is that more of a artifact of a lot of largenumbers or you guys think some traction there that you hadn't seen before?

Jerry McNamara

Overall our international pipeline's billing very well andtiming is always difficult to predict, and so we expect overall theinternational system sales to grow, rest of world versus Europe it's hard toforecast them separately.

Lonnie Smith

But we started out in Europeand so we have -- we are more established there. We are building also expandingour distributors in the smaller, rest of world markets, and as that happens asJerry says the dynamic is going to be -- [most] its body as some of these guyscome up. But everyone's in a while they really start to gain some traction andthe early that [stay up] it's just the way the markets develop. It's usuallyEurope, then comes United States,then its back to Europe and then it's the restof the world and so we are just in that cycle.

Vincent Reece -Wachovia

Okay great thanks for taking my questions.

Operator

The next question comes from Rick Wise from Bear Stearnsyour line is open.

Rick Wise - BearStearns

Good afternoon everybody.

Lonnie Smith

Rick.

Rick Wise - BearStearns

Let me pick up on the couple of comments that were discussedbefore. The pipeline is strong you made it very clear, US and OUS. Is itequally strong by procedural dVH and dVP or is dVH carrying more of thebacklogs team, as it were at this point?

Aleks Cukic

Again Rick I think what we have talked about in the past andit remains true, is that, that a program that we are trying to establish be itUS or OUS has a number of specialties in mind.

In other words, when we are selling a system we are tryingto incorporate Urology and Gynecology and Cardiac and general surgery. That'sno different from OUS and US. So I would say that as we made clearProstatectomy and Hysterectomy are the fastest growing procedures.

But I would be careful to think of these as specific to oneprocedure. In other words, they are buying it only for Urology or they'rebuying it only for Gynecology. When they come in, they tend to have supportfrom multiple specialties.

Now what happens after it's installed, and what that mixlooks like is different. But you could suspect that Urology is going to get onquickly, it's going to grow faster. Gynecology and Cardiac in general are goingto get on etcetera, etcetera.

So, I would say that that hasn't changed, but urology on a globalbasis is definitely proliferating Gynecology slower than it is in the UnitedStates, but it is spreading around the world, and then General Surgery andCardiac are slow-steady areas.

Rick Wise - BearStearns

Lonnie was kind enough to remind us how critical theconsumer or the patient is to driving a robotic choice in surgery. Is thatprompting you maybe particularly in the dVH areas, any unique marketinginitiatives Aleks?

Aleks Cukic

Again, I think when you are using terms like marketinginitiatives, I think if you look at what has happened and continues to happenin Urology, and I would say it's actually happening in Gynecology, is that,hospitals recognize the value and the power of a women's health initiatives,and so you will see da Vinci fit in very nicely to minimally invasivereproductive procedures for Myomectamy or pelvic floor reconstructions orbenign or malignancies. And that is taking place.

And certainly where you reside on the east coast, I'mgetting close all the time of people that are hearing radio ads, televisionads, billboards etcetera. You know we are doing things like, putting togetherdVH.com. We have a number of marketing support in internet-focused areas, butthe patient awareness is something that hospitals do, and some of them do itreally very well, and I think are the recipients of those patients.

Rick Wise - BearStearns

Let me focus on two questions that both have implications oflooking ahead. As we wrestle with our models, I realize it's early to thinkabout '08 and you are not ready to give '08 guidance today.

But just directionally so we can think about it, is it - twoquestions essentially. Is it reasonable to think about sequential unit growthof some magnitude for the next three to five quarters as far as the eye couldsee? How do we just conceptually think about that?

And second, I have to note that one of my favorite hobbyhorse is the possibility of positive operating leverage is quite evident thisquarter with EBIT income up, I think 110% of my eyes are working here, wellabove the [64%] you grew revenue.

Is it reasonable to think that that kind of leverageconceptually continues into the next year?

Ben Gong

Rick this is Ben. So we will definitely give you someguidance next year in our next conference call. I don't think we are preparedto give you guidance on 2008 today.

We are certainly continuing to see momentum from the thirdquarter to the fourth quarter. So generally speaking, things are going verywell, definitely driven by dVP going at 65% year-over-year and dVH at 175%.

So there's likely to be growth next year absolutely. But wewill get more specific about that next quarter. And then getting to your pointon leverage, I think Lonnie, expressed some of this earlier, is that. It's notour intent to continue to lets say drive our margins higher.

As an example, when we launch new products we said in thepast that our new products were at lower gross margin when we launch them,because our costs on delivering new products is a little bit higher.

So, in our efforts to continue to drive procedure growth,use the existing procedures or new procedures, we are going to make sure thatwe put our products out there that can drive that growth and we are not sointent on driving that leverage if you will higher.

Lonnie Smith

Well, and as Ben pointed in the numbers this quarter, ourR&D effort is up, our development efforts are up, and we will continue toinvest there as fast as we can find the talent that really drives it.

So, we are in this, as I pointed out to you couple of times,we are in this for the long-term and trying to build a business that last. Andwe will continue to invest in the business, but we will invest where we thinkwe have the most leverage.

And so I wouldn't count on a whole lot of -- we may get somebecause it's growing faster than we can invest, but we are not trying to get alot of operating leverage at this point of time.

Rick Wise - BearStearns

Got you. Just one last quick one or not, in recent weeksthere was some anxiety about possible emerging competitive products in Korea,and there is on going discussions about other modalities presenting incrementalcompetition for da Vinci. Aleks, Lonnie, how should we think about some ofthese issues, and maybe just update us with your thoughts and just?

Lonnie Smith

Let me ask, let Garyanswer that question.

Rick Wise - BearStearns

Okay.

Gary Guthart

Anyway, as we look at it, there are competitive groups thatwe know of working in Asia, Europe, and North America.The recent announcement from Koreaand other places has not been a surprise, nor do they represent an eminentthreat.

We think our barriers to entry are significant from productsthat produce outstanding clinical results, are easy to operate, reliable and costeffective. There are broad and growing range of instrument and imaging optionsthrough our pipeline of significant new products that will both increaseefficacy and easy of use for our products and new procedures and in existingprocedures, a strong relationship with our customers through our field andmarketing organizations, a deep patent portfolio and a strong set of regulatoryapprovals. That said, we believe that computer aided surgery is in its infancyand we cultivate relationship with research centers and third-party groupsworldwide to help us develop ideas and monitor trends. We believe we are takingthe necessary steps to remain leader here and we will keep watching anddeveloping.

Rick Wise - BearStearns

Thank you so much.

Lonnie Smith

Thank you. We have time for one more question.

Operator

And our next question comes from [David Louis] for MorganStanley. Your line is open.

David Louis - MorganStanley

Good afternoon. Running tight on task, I'll be brief here. Idon't want to beat the dead horse, but I want to come back to margins and thathas been and obviously senior management less bullish on margin increases. But,just on gross and SG&A, if you think about gross margins, there seem to befour factors inputting to margins this quarter which would be geography mix,price increases, currency and absorption and we've got good numbers I think intwo or three of them. It appears that absorption was over a 150 bps and Iappreciate Lonnie's comments on passing the stock off to customers. But,absorption doesn't appear to be something that would go away. So, I guess I amhaving a hard time seeing how gross margins only go up a 100 bps in thisquarter. Is it something that, go ahead.

Lonnie Smith

I will let Ben answer those numbers. You are talking aboutabsorption, internally we don't run the company on fully absorbed accounting,we don't. We run it by fixed and variable cost. We have to report on GAAP,understand that, but internally we manage our fixed cost and we manage ourvariable cost. And so, there is leverage and is depending upon how quickly youinvest, how hard you invest in fixed cost as you grow revenue. And so, that'swhat happens. But, it's always a trade off. We tend to try to be thoughtful andconservative in our investment for fixed costs, but we try not to be foolisheither, because as Garypointed out with the very beginning of what we think is going to become a largeand dynamic market. And we are the leaders here and I mean we are the leaderswho tend to remain the leaders. And so, we'll be investing in fixed costs,which will reduce some of that "absorption" in the process and itcould be lumpy. So, I cannot be totally predictable. When we are ramping up onprototypes that raises fixed costs, when we are investing in a new area withsome engineering staff that raises fixed costs, so I'll just tell you that I amnot saying we won't have some margin improvement at times. We also have timeswhen we [went up with it] because we've invested more heavily in fixed costanticipating the future.

Ben Gong

All right. That was extremely well said the only thing Iwould just point with you and you are on the right track is, there were someproductivity gains that we had, I would like to call them productivity gains.And that's why we are giving the guidance of 68% gross margins, which is higherthan the 67%. Let's say that we are driving towards at the beginning part ofthe year, and it's hard for us to estimate what's going to go on with thegeography mix. But, back to Lonnie's point, while we might be enjoying some ofthese productivity gains right now that we are certainly not afraid to investin certain things that are going to be beneficial for our future products.

David Louis - MorganStanley

Okay. And then just two more quick ones; On utilization, Benyou mentioned that obviously, there could be two things that impactedutilization this quarter, one being obviously seasonality and another one isgeographic mix. Historically, you've been up on utilization sequentially evenin sort of a slowest third quarter. So, is that bigger driver this quarterinternational versus utilization or they are about even?

Ben Gong

Well, the procedural growth in Q3 in the past has alwaysbeen much lower than in the previous quarters and the seasonality this quarterwas there, seasonality was also there in the last third quarter. So, what weexperienced this quarter is not necessary that's different than what we had inthe third quarter of last year. So, we know that the number is in beyond fivepercent or something like. But, when we step back and take a look at whathappened, the same sort of seasonality hit us in the third quarter this year aslast year.

Aleks Cukic

And David just as a reminder, and that the practical side ofit, as GYN becomes a larger percentage of our business, aside from the GYNoncology procedures, most of those procedures have some elective nature tothem. So, they can be postponed. For example, benign conditions and pelvicfloor, pelvic team issues and myomectomies, etcetera. So, as you look out overthe -- I mean, the core of this is patients pushing off elective surgery. So,it's just a, but sort of a subtle footnote there.

David Louis - MorganStanley

Okay. Just lastly and I'll end here. Can you just rank inorder of procedure number; because I don't think you're going to give us anyrelated metrics, myomectomy, prolapsed hysterectomy in order of procedurevolume?

Ben Gong

Well, hysterectomy is certainly our largest procedure ingynecology. And we've been at the myomectomy for a little while longer thansacrocolpopexy. So, we actually have some momentum going on there. Sacrocolpopexyis a very fast grower, so even ranking those two against each other is going tokind of tough. They are both very strong procedures for us and they are bothgrowing very fast.

David Louis - MorganStanley

Okay. Thank you very much.

Lonnie Smith

Thank you. That was our last question for today. And as Isaid previously in these calls we focus on the financial metrics such asrevenues, profits, cash flow, and procedures. But, our organizational focusremains on increasing patient value by improving surgical outcomes and reducingsurgical trauma.

We believe that adoption is procedure specific, as it's beenmentioned and patient driven. And it's our goal to help the surgeon deliver asignificant improvement in the value to the patient and we developed a finepatient value as efficacy of the procedure divided by how invasive it is.

And we hear stories daily of patients returning to theirjobs and their normal lives literally days after surgery. Such as a young womenwho is a key aid in the congressional campaign and was diagnosed withendometriosis and two large myomas, just gets to your point. She was insignificant pain and required a myomectomy. She had two close relatives in thecommunity she lives, both who were gynecologist. But, in the end, she chose togo to a gynecologist who could perform the procedure with the da Vinci Systemand she was back on the campaign trial in three days.

Another patient of Dr. Mihaljevic, a cardiac surgeon atCleveland Clinic wrote to Dr. Mihaljevic saying, dear Dr. Mihaljevic thank youfor bringing robotic mitral valve repair to the Cleveland Clinic. Although, mymitral valve was diagnosed by another Clevelandhospital, with due diligences I found that the clinic alone offered roboticsurgery with a potential of a speedy return to normal activity, a more normallife. Indeed, as I write this letter I've been out of surgery fewer than sixdays and I can walk miles everyday, drive and do almost everything. My recoverydoes not include narcotics, and I had never experienced pain above the LevelII. My confidence was well placed and I thank you. My point is that thepatients like this are the strongest advocates of surgery with the da VinciSystem and are the underlying strength of our business.

In closing, I assure you that we remain committed tofocusing on the quite a few things that truly make a difference, as we striveto take surgery beyond the limits of the human hand.

That concludes today's call. We thank you for yourparticipation and support in this extraordinary journey. We look forward totalking to you with again in three months.

Operator

Thank you for participating in today's conference call. Youmay disconnect at this time.

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Source: Intuitive Surgical Q3 2007 Earnings Call Transcript
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